An Administrative Law Judge has held, consistent with a decision by the Appellate Division in April 2014, that the retroactive application to 2008 of a 2010 statutory amendment to Tax Law § 631(b)(2) concerning the treatment of installment payments by nonresident shareholders of an S corporation would violate the taxpayers’ Due Process rights. Matter of Jeffrey M. and Melissa Luizza, DTA No. 824932 (N.Y.S. Div. of Tax App., Aug. 21, 2014).
The petitioners, Mr. and Mrs. Luizza, were nonresidents of New York. Mr. Luizza owned 100% of the stock of an S corporation that did business in New York and other states, and in December 2007 he agreed to sell the company to an unrelated purchaser. At the purchaser’s request, Mr. Luizza agreed to an election to treat the sale as a deemed sale of the company’s assets pursuant to Internal Revenue Code (“IRC”) § 338(h)(10), but Mr. Luizza wanted the purchaser to reimburse him for any “‘costs and negative tax consequences’” of the election. The purchaser requested instead that the tax consequences of the election be addressed up front, so Mr. Luizza and his accountants researched the federal and New York state tax implications, including the effects of Tax Law § 631(b)(2) and other New York State authority available in late 2007 and early 2008. Mr. Luizza was advised by his tax advisors that there would be no tax consequences in New York as a result of the election, and he therefore agreed not to require the purchaser to increase the purchase price or to provide indemnity when the sale closed in March 2008.
Mr. Luizza reported a capital gain of approximately $8 million on his 2008 New York nonresident income tax return but did not include the gain as income attributable to New York sources.
Background to the 2010 statutory amendment. In 2009, the Tax Appeals Tribunal held that, under Tax Law § 632(a)(2), nonresident shareholders did not have New York source income when they sold their stock in an S corporation where an election had been made under IRC § 338(h)(10). Matter of Gabriel S. & Frances B. Baum, DTA Nos. 820837 & 820838 (N.Y.S. Tax App. Trib. Feb. 12, 2009). A few months after Baum, an ALJ reached a similar conclusion in Matter of Myron Mintz, DTA Nos. 821806 & 821807 (N.Y.S. Div. of Tax. App., June 4, 2009).
In August 2010, Tax Law § 632(a)(2) was amended to specifically provide that gain recognized by a nonresident shareholder of an S corporation will be treated as New York source income based on the S corporation’s New York business allocation percentage for the year in which the assets were sold. The amendment was made applicable to years beginning on or after January 1, 2007, that were open for assessment or refund.
In reliance on the statutory amendment, the Department took the position that the Luizzas had to allocate a portion of the capital gain to New York and issued a Notice of Deficiency for nearly $200,000, including tax and interest.
Issue and decision. The Luizzas argued that the retroactive application of the amended Tax Law § 631(b)(2), under the circumstances, violated their right to Due Process. The ALJ agreed. He relied on an analysis of the governing factors that were set out by the Court of Appeals in James Square Assocs. LP, et al. v. Mullen, 21 N.Y.3d 233 (2013), which are: (1) the taxpayer’s forewarning of a change and the reasonableness of reliance on the old law; (2) the length of the period of retroactivity; and (3) the public purpose for retroactive application.
With regard to the first factor, which has been held to be the “‘predominant’” factor, the ALJ found that neither Mr. Luizza nor his advisors had any knowledge or reason to believe in 2008 that there would be a statutory change two years later, that Mr. Luizza reasonably relied on the law applicable at the time of the sale, and that Mr. Luizza was harmed by his reliance, since he did not have the opportunity to seek a higher purchase price or require an indemnity from the purchaser as he originally intended. In analyzing the second factor, the length of the period of retroactivity, the ALJ looked to the Court of Appeals decision in Caprio v. New York State Dep’t. of Taxation and Fin., 117 A.D.3d 168, 177 (N.Y. App. Div. 1st Dep’t 2014), which had reviewed the same statutory amendment and found that the period of retroactivity, which in that case was three and a half years, was excessive. While the period in Luizza was not as long as that in Caprio, it was significantly longer than the 16 months found to be excessive in James Square, and long enough for Mr. Luizza to have had a reasonable expectation he could rely on the previous statute. The ALJ also rejected the Department’s argument that the amendment was merely intended to “clarify the concept of federal conformity.” The ALJ found “persuasive” the Court of Appeals’ conclusions in Caprio that there was no legislative history to support the Department’s position that the amendment was correcting any specific defect, rather than changing the statute to adopt the position requested by the Department. Finally, the ALJ rejected the Department’s argument that the retroactivity had a valid public purpose in correcting the “mistakes” of the Tribunal in Baum and an ALJ in Mintz, since he concluded the Appellate Division had clearly found that the purpose of the amendment was not corrective but to raise tax revenues by $30 million.
The arguments made by the Department in this case had been resoundingly rejected by the Appellate Division in Caprio, and so it is no surprise that the ALJ rejected them as well, particularly when the facts clearly indicated that the taxpayer specifically researched the issue and reasonably relied on the statutory language as it existed before the statute was amended, and before any public record cases would have put him on notice that the Department was arguing a contrary position.
At press time, it was unclear whether an exception will be filed by the Department. However, since the statute has now been amended, and the new language will apply from 2010 on, it is not entirely clear what public policy would be furthered by the Department’s continuing to argue that the new statute must be applied to what must be an increasingly limited group of taxpayers who entered into similar transactions before 2010, are open for assessment or refund for those years, and can prove that they reasonably relied on the prior statute.